Bucks, Buckets and Better Cash Management

“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume cash.” – Warren Buffet, Fortune Magazine 1977

As an investor, I have a complicated relationship with cash. I’m always on the look out for how to get more cash flow, but at no point do I want to hold too much cash. To put it plainly: cash is a risky investment (in my view).

Cash is risky? What could I possibly mean by this? Well, I find the above quote from Warren Buffet to be instructive. Inflation is a fact of life and the enemy of the saver and holder of cash. Every year, prices go up for your food, water, cell phone, newspaper (yes, I actually read the paper), movie tickets and everything else you use and enjoy. When Buffet penned the above quote, inflation was running at 15% per year. If you had $100 in cash from the year 1976-1977, then after only a year’s time that cash would only have been “worth” $85 in terms of what you could actually buy with it!

Typically, inflation is more mild and averages only about 2% per year, but that’s still 2% per year of your purchasing power that is being eroded. If you held that same $100 for 10 years and inflation averaged 2% per year, then at the end of that 10-year period your cash would only be worth $80…that’s brutal.

Viewed another way, by holding cash you are speculating on the direction of the economy. Specifically, you believe that the economy is going to crash, and your cash is the safest place to be. Occasionally this is the case but is the exception rather than the rule. The economy tends to grow each year, the stock market tends to go up, inflation tends to be positive and the real value of your cash tends to go down. If you were all in cash at the beginning of 2007 or in March of this year, then things worked out pretty well for you, but being is cash for the past 10 years would have been…a bad bet.

We all need cash to run our daily lives and, as disciplined investors, we need to hold long term investments like stocks to build wealth. But we are also nervous (and rightfully so) about being too thinly capitalized; having too little cash that we can’t adequately deal with an unexpected expense or losses in the market.

What do we do with our cash? We shouldn’t just keep it in a bank account, and we can’t just put it all in the market, what else is there? How can we manage our cash better to ensure it’s available when we need it and we at least mitigate the corrosive effects of inflation?

In this post, I’m going to walk you through how I manage my cash: how much I keep in cash, the different “buckets” I’ve built and the different instruments that I employ.

The Buckets Approach

Cash Buckets refer to the different places for you to store your cash. Each bucket has a different purpose and should only be used for that purpose. I personally use 3 buckets:

Emergency funds create a financial cushion that can keep you solvent in a time of need without resorting to credit cards or loans. It can be especially important to have an emergency fund if you have debt, because it can help you avoid borrowing more and ensure you are able to continue to service the debt you already have; thus, keeping your credit intact and situation stable.

Your Emergency Fund depends on your financial circumstances, but 3-6 months (hopefully closer to 6) is a good rule of thumb. If you or a spouse loses a job or your business struggles, then you can use the money to pay for necessities or to supplement your unemployment benefits.

In practice I use a high yield savings account and a brokerage account for this bucket; I’ll speak to why I have the separate account in a bit.

High Yield Bucket: This is my medium to long term bucket and is where I store cash-like investments that provide a higher yield but typically involve some level of risk (even if it’s small) or are locked up to maturity. The purpose of this bucket is to hold investments that are highly liquid to either pay for an expense I have down the road (like tuition in a year, etc.), to fund future investments, or as an investment in and of itself. As you will see, you can get pretty creative with the High Yield bucket and it can serve as a standing investment for you.

Tools of the Trade

Now that you understand the different buckets and their respective functions, let’s talk about the different accounts and instruments that you can use in each.

Operational Bucket

The best account type to use for the Operational Bucket is a Checking account so you can easily make deposits, take withdrawals, set up bill pays and transfer funds. Most banks tie the interest rate of deposit accounts to market funding rates and, in most cases, even below that. The most common benchmark funding rate is the prevailing Federal Funds rate set by the Federal Reserve; recall that this is the rate at which banks lend to one another on short, overnight loans. Right now, the Fed Funds rate ranges between 0% and .25% and is expected to stay there for a long time. If a bank can obtain cheaper funding through the Fed Funds market than through deposits, then we would expect them do so. So don’t expect many banks to be offering checking account interest rates much above 0% anytime soon.

With that said, it’s not quite a race to the bottom. All banks run their business differently and while most only offer a pittance for depositing money with them, an impressive number offer a relatively high yield, but often come attached with hoops to jump through.

1. Citi Elevate High Yield Checking

Citi’s Elevate Checking is an online bank available to consumers in most states (see the Disclosures section at the bottom of the page by following the link. Curiously, California and Florida are not eligible). They offer a tiered High Yield checking option that allows you to earn up to 1.01% on your cash if you meet certain requirements. The tiers are as follows:

For deposits over $25,000 this offer is pretty attractive. For example, if you keep $50,000 in your checking account regularly then you would earn ~$333.00 per year. This results in a blended yield of around .66%; about 30x higher than many competitors.

Some other features to keep in mind for Citi:

• Minimum Deposit and Balance Requirements: There’s no minimum opening deposit. To waive the $15 monthly maintenance fee, you need to maintain an average monthly balance of $5,000.
• Account Opening Bonus: None currently, but I do see them offer bonuses regularly so check back.
• Withdrawal Features: Unlimited ATM fee waivers and reimbursements on Citi and Non-Citi ATMs.
• Mobile Features: Citibank has a mobile-friendly website and app. The app includes Zelle for external money transfers.

2. Ally Bank High Interest Checking

Ally Bank is another popular online retail bank that offers a two-tier deposit yield structure through Ally High Yield Interest Checking. The deposit tiers are lower than Citi’s, but also cap out at lower rates. The interest rate structure is as follows:

What’s interesting to note is that for deposits <$15,000 or >$25,000 Citi is actually a better option, but if you have a balance between that range then you’ll be better off using Ally. The APY you receive from Ally is not progressive like Citi’s. If your balance is just over $15,000, then you will receive .50% on the entire amount. With Citi you only receive 1.01% on the portion of the account over $25,000.

Other Features to keep in mind for Ally:

• Minimum Deposit and Balance Requirements: There’s no minimum deposit or ongoing daily balance minimum.
• Account Opening Bonus: None that I’ve observed.
• Withdrawal Features: Ally Bank never charges ATM fees and provides unlimited reimbursements for all third-party ATM fees.
• Mobile Features: This Android- and iOS-compatible account features mobile check deposit, ATM finder, online bill pay, and internal and external transfers using the Zelle money transfer app.
• Possible Fees: Overdraft, outgoing wires, and international transactions. Ally at least tries to be transparent about their fees. See Fees section by following the link above.

3. Chase

For full transparency, I want to disclose that I use Chase for all of my Operational banking needs. The interest rates offered at Chase are essentially 0%:

If earning interest is your primary motivation, then Chase probably isn’t for you. I use Chase because I’ve always been very impressed with the customer service. Whenever I have called the service center I have gotten through right away, they already have my accounts pulled up based on the phone number I use to call, and the staff is helpful. In addition, I still like the physical branch presence that I get with Chase which is unavailable with Citi and Ally (at least where I live). I don’t often go to a branch anymore, but at one time I was making a lot of cash deposits for a business I ran and needed to visit a physical location. For me, the biggest drawback of a solely online bank is that you can’t deposit or withdraw cash. If this a consideration for you, then I suggest using a bank with branches and isn’t solely focused on the online market.

Emergency Bucket

As mentioned previously, your Operational Bucket is for managing your short-term finances; receiving deposits and paying bills. Simply due to the nature of the account your options for saving and earning interest are more limited. On the other hand, your Emergency Bucket should only be used as required and, ideally, should be tapped infrequently. As such, the Emergency bucket has a more medium-term time horizon, which means that you can get more creative.

Savings Account

A great place to start when building your Emergency Fund is by opening a savings account. Savings accounts typically offer a higher rate of interest compared to their Checking counterparts. This gives you a simple way to save and earn some additional interest.

As we observed for Checking Accounts, the interest rate that you receive in savings can differ substantially across banks. It pays to look at different banks and determine which best fit your needs. Below are some ideas:

1. Citi Accelerated High Yield Savings

Much like their Checking account option, Citi offers a competitive Savings account that pays 1.2% on all balances with no account minimum. A monthly service fee of $4.50 and a $2.50 non-Citibank ATM fee apply to the Citi Accelerated High Yield Savings account if you do not have an accompanying Checking account or do not maintain a balance of $500. However, even if you forgo the Checking account this is still pretty marginal in absolute terms.

2. Marcus by Goldman Sachs

When it comes to posh, bespoke banking, Goldman Sachs has always set the standard. Recently Goldman has made a push into retail banking by introducing Marcus, which is their online banking brand intended for everyday consumers. They offer a competitive Savings account paying 1.05% on all balances with no minimum. I personally use Marcus as my savings account of choice. It’s a pretty no frills option, but I like the simplicity of the website and the app.

Keep in mind that for all Savings accounts (regardless of the bank) the interest rate is variable and can adjust at any time. You’re not locked into that rate and may find in the future that rates drop. If you’re comfortable locking your money up for a period of time, then I suggest investigating fixed rate options such as CD’s.

Certificates of Deposit (CD)

A certificate of deposit (CD) is a product offered by banks that pay a fixed rate of interest in exchange for leaving a lump-sum deposit untouched for a specified period of time. Almost all retail financial institutions offer them, but rates can vary substantially across firms. Shopping around for CD’s is crucial for finding the best rate. You’ll likely encounter a wide range of options and some slightly more exotic features.

How Does a CD Work?

CDs function more like an investment than the savings accounts previously discussed and are more comparable to bonds in features and design. The big differentiator when it comes to CDs is that CDs require you to lock your money up for a set length of time. During this period you will not have access to the money. You can potentially surrender the CD before it matures, but often will have to pay a penalty and/or forgo the interest you earned. When buying a CD, go in with the mindset that you are comfortable leaving this money untouched until it matures.

Below are the features to look for when evaluating CDs:

1. The Interest Rate: CD’s pay a fixed rate of interest and a predictable return on your deposit over the time period. However, a fixed interest rate may become a disadvantage if rates later rise and you’re still stuck at your current rate. As such, be careful with the term you choose.
2. The Term: This is the length of time you agree to leave your funds deposited to avoid any penalty (i.e., 6-months, 1-year, 18-months, etc.). The term is also referred to as the duration or maturity. At maturity, the principle you deposited and the interest you earned are paid out to you.
3. The Principal: This is the amount you agree to deposit when you open the CD. Most CD’s are sold in increments of $1,000 and, generally, the more your deposit the better your rate will be.
4. Call Provisions: Some CDs include provisions that allow the bank to call (i.e. buy back) the CD from you after a certain period of time (usually at 6-month intervals). This gives the bank optionality that if rates fall, then they can effectively break your contract, pay you out and finding cheaper financing. I saw a lot of these in early 2019 when rates were high for the first half of the year, but everyone was forecasting that the Fed would cut and in 6 months rates would be lower. I generally try and avoid CDs with these features. The whole point of a CD (in my view) is to know I’m getting the rate I signed up for. I don’t like the idea of the bank changing their mind later.
5. Interest Frequency: Usually, CDs pay out their interest at maturity. If you decide to invest in a longer-term CD (+1-year) then you might encounter provisions that pay out throughout the year; usually on a semi-annual basis. This might be of interest if you’re putting significant money into a CD (i.e. six figures) because you can then use the income. However, if you’re putting $10,000 into a CD at 2% (and right now, that is basically unheard of), I don’t see what $100 in 6 months is really going to get you. Plus, this is your emergency fund so you shouldn’t necessarily be looking to get interest income anyway. Furthermore, increased interest frequency typically is also accompanied by a lower interest rate and, for me, that’s not a good trade off.

How Are CD Rates Determined?

CD rates are closely linked to short-term bank financing costs. As such the rates that you can expect to get on a CD will closely follow the Federal Funds Rate. When rates are low, then banks can finance themselves cheaply in the overnight Fed Funds market. Consequently they have less incentive to attract deposits through CDs. When rates are high however, banks have substantial incentive to offer competitive CD rates in order to attract deposits. This is why many major banks offer relatively low yields in their CDs; they are large, have significant deposits and can easily find overnight financing in the Fed Funds market. Smaller banks and online banks on the other hand need to attract deposits. Accordingly they may offer higher rates in order to bring in depositors.

Bank CD rates will also differ based on the bank’s business. Large banks typically have conservative loan portfolios and typically will not offer high interest personal or unsecured loans. Consequently, the interest income that they bring in per loan is relatively low. In order to maintain a suitable spread and make a profit they need to finance themselves cheaply and will offer low interest rates to their depositors as a result. Small and online banks on the other hand are more aggressive in their loan activity. Their defaults are likely higher, but so is their net interest margin so they can afford to offer higher CD rates to finance their loan operations.

How Safe are CDs?

Short Answer: Very safe.

Long Answer: Like your checking and savings deposits, CDs are FDIC insured up to $250,000 per borrower. Even in the unlikely (but not unprecedented) case that the bank fails you are still guaranteed to get the money back that you put in the CD provided the total value of your CD is less than or equal to $250,000. This makes CDs a low risk investment and suitable for your Emergency Fund.

Where to Find Good CDs?

Bankrate.com does a good job of compiling CD rates each month from a host of different banks and credit unions. This will provide you with a good survey of what the most competitive rates are right now.

Marcus by Goldman Sachs also offers compelling CD rates right now (they usually do from what I have observed). They offer both short term CD options ranging from 3-13 months and long term CDs from 6-months to 6-years (which they term “high yield CDs”). If you are considering Marcus for your savings account, then consider pairing it with a CD in a one-stop-shop.

Money Market Funds

The final product that I would like to address with respect to the Emergency Bucket are Money Market Funds (MMF). Money Market Funds are a type of mutual fund that invests in cash, cash equivalents, and high quality, highly liquid short-term debt securities. As a result, these funds offer a yield and a low risk place to store your cash.

How Do Money Market Funds Work?

Like all mutual funds, Money Market Funds issue shares to investors that are redeemable back to the fund company at the Net Asset Value (NAV). Unlike the typical mutual fund however, the sponsor (i.e. the company that sells the fund; Vanguard, Fidelity, Federated, etc.) attempts to keep the NAV as close to $1 as possible. Money Markets are supposed to substitute for cash and consequently be very safe. “Pegging” the NAV at $1 is designed to protect investor principal. Any interest earned by the underlying securities of the MMF is paid out to investors.

Money Market Funds will generally invest in six categories of securities depending on the type of fund:

• Certificates of Deposit – We talked about those at length above!
• Treasury Bills – Short term debt issued by the US Government
• Commercial Paper – Short term, unsecured debt generally issued by corporations and banks.
• Asset Backed Commercial Paper – Short term, secured debt issued by banks and corporates.
• Repurchase Agreements (Repos) – Short term debt secured by Treasury notes issued by large investors and banks.
• Municipal Notes – Short term notes issues by state and local governments that serve a similar function to commercial paper used by corps.

Types of Money Market Funds

Not all Money Market Funds are alike and despite the attempt of funds to peg the NAV at $1 some carry more risk than others. Below are the four broad categories of funds which I have listed from least to most risky:

• Treasury Funds: Invests all assets in standard US government securities like bills, notes and bonds.
• Government Funds: Similar to Treasury Funds. The majority of the portfolio is invested in Treasury securities but with expanded holdings to include agency debt (like Fannie and Freddie for example) and repos.
• Tax Exempt/Muni Funds: Offer interest that is exempt from federal income taxes. Invest in short term municipal securities like VRDOs and VRDNs (basically floating rate paper similar to commercial paper but for governments). There also a number of state specific funds (particularly from CA and NY) that offer interest that is also state income tax free.
• Prime Funds: Invest in a wide range of notes from the Treasury, agencies, corporations, banks, insurance companies, and large private investors.

It’s easy to see why the riskiest type of MMFs are Prime Funds. The other three fund categories are invested principally in short term government debt. Prime funds are tapping many different kinds of issuers. As a result, the yield from Prime Funds is usually quite a bit higher than their Treasury or Government counterparts. Even though all four types of funds try to peg there NAV to $1 (suggesting there is no risk at all), this hides the truth.

How Safe as Money Market Funds?

Occasionally, during periods of significant market stress, the NAV of a Money Market Fund may fall below $1; a situation known as “breaking the buck”. The nature of the short-term investments in the fund make it unlikely that the fund will experience losses. It is extremely rare that a bank with a credit rating sufficient to sell commercial paper (which usually matures in less than 270 days) would default, but it’s not without precedent. Additionally, if investors get nervous that a fund may not be able to meet its obligations, heavy liquidation may overwhelm the fund’s ability to sell assets and consequently cause the NAV to fall below $1.

Prime Funds are the riskiest type of MMF because they pose the greatest probability of breaking the buck. Prime funds hold the riskiest securities and if there are significant redemptions from the fund, then the fund may struggle it sell its holdings at fair prices. Just compare the holdings from the BlackRock Federal Trust Fund (TFFXX) and the Federated Prime Obligations Fund (POIXX). The BlackRock Fund holds only Treasury and government agency debt. The Federated Fund holds a huge variety of securities from a wide range of issuers some of whom aren’t even banks, but instead entities of wealthy families (which is very interesting!).

I want to stress that MMFs are definitely safe investments and something you should consider for your Emergency Fund. The whole point of this discussion has been to try and educate that they are not 100% risk free as it might appear from the surface. In the 50+ years they have been in existence these funds have only encountered problems a handful of times and even when they did lose money, it was only on the magnitude of 2-3%. Obviously not what we are trying to accomplish, but it’s not like they went to zero!

Using Money Market Funds

In order to purchase a MMF, you will need a brokerage account. Fund companies like Fidelity, Vanguard and Schwab offer access only to their suite of products. Brokers like TD Ameritrade and Merrill Edge will offer a greater range of options from managers like BlackRock and Federated. The Funds are all very similar in construction, but make sure that you choose one with a large AUM as this promotes better liquidity.

Since the Fed cuts in early March, money market rates have gone into the basement. For example, the Fidelity Money Market Fund (SPRXX) has a current yield of 5 bps (.05%) on an annualized basis. This isn’t even enough to cover the expenses of the fund. Similarly, the Schwab Value Advantage Money Fund (SWVXX) has a slightly better yield at 14 bps (.14%), but with an expense ratio of 34 bps (.34%) you’re still going to have to pay to own it.

With yields as dismal as these, I just don’t see MMFs as a good vehicle for storing your cash right now. Not so long ago (like 12 months ago) you were getting 2.5% in these funds, but with the expectation that the Fed will keep rates at 0% for years to come, I think it will be a very long time before these funds are attractive again. However, MMFs can be a useful product and something you should keep in your quiver for the future.

High Yield Bucket

Finally! We have made it to the third and final Bucket in our cash management strategy: The High Yield Bucket! As I mentioned previously, your HY Bucket is where you can get the most creative. The goal remains to keep cash and cash-like investments, but here you can allow yourself to take a little more risk in hopes of earning a little more yield. These products are not available through a bank so you will need to have a brokerage account set up in order to use the strategies we will discuss. In particular, I would like to address 2 different products:

1. Laddered Bond ETFs
2. Ultra-short Fixed Income ETFs/Funds

Laddered Bond ETFs

ETF bond ladders are a fairly recent innovation in the world of fixed income investing having come onto the scene in 2010. The concept is the same as any bond ladder except applied with ETFs rather than individual bonds:

• Each ETF has a set maturity date and the underlying portfolio is constructed with many bonds that all mature around the same date; usually within 6-months of one another.
• The bonds trade and accrue interest over their life. When the final bond in the portfolio matures the ETF is delisted from the exchange and all proceeds are paid out to the investor; just like a normal bond.

Essentially what you get is a bullet portfolio of bonds that trades like a stock, matures like a bond and provides the diversification of a fund. These features are very useful for fixed income investors. You still get “certainty” of principle at maturity but without the exposure to the credit risk that comes with holding the bonds of individual issuers.

The ETF structure significantly simplifies the trading when compared to buying individual bond issues. I’m not sure if you have experience trading bonds, but, in short, they don’t trade like stocks. The ETF structure does away with all of that, so you don’t have to worry about trading.

ETF bond ladders are a great option for your High Yield account as they allow you to take on a bit more risk, pick your maturity date and ensure that the cash is returned to you at a specific time. This is a highly efficient mechanism for pulling down a little additional yield and something that I have used in practice.

Interestingly, not many companies have gotten into this space and BlackRock is the largest manager by far. Their iBond portfolios offer both Corporate (i.e. taxable) and Muni (i.e. tax exempt) ladders. If you are in a high tax bracket, then you might want to consider the muni ladders as they will provide your High Yield bucket with tax free income. Otherwise, you can mix and match depending on your personal preference. All of the bonds in the iBonds portfolios are rated Investment Grade (BBB and up) so you are dealing with large issuers of reasonably high credit quality.

Additionally, BlackRock’s iBonds Ladder Builder provides a useful tool that you can play around with to build a custom portfolio that meets your yield preference and maturity profile. Below is simple, sample corporate bond ladder that I built that contains 3 bonds which I have equally weighted. The weighted yield to maturity of the portfolio is approximately 1% and one-third of the portfolio matures in December of each year until 2022.

If you’d like to learn more about BlackRock’s iBond offering, then check out their website here. I have also attached a Case Study which provides good description of how the portfolios work and how they have performed in the past.

It’s important to keep in mind that if you decide to incorporate these into your High Yield Bucket that you are still investing in bonds; so, you’re fairly removed from the cash market. However, you have significant flexibility when it comes to picking your level of risk and maturity schedule, thereby offering a high level of certainty that you will get your money back at maturity.

Ultra-Short Bond Funds

Ultra-short bond funds are basically what they sound like: a bond fund that invests only in fixed-income instruments with very short-term maturities; typically, around 1-year. At first glance this may appear similar to the definition that I offered for Money Market Funds. While the maturity profile of Money Market Funds and Ultra-Short Bond Funds may be similar, the objectives of the funds and the underlying securities are very different.

For example, money market funds may only invest in high-quality, short-term investments issued by the U.S. government, corporations, and state and local governments. On the other hand, ultra-short funds have significantly more flexibility to pursue higher yields by investing in riskier assets. Furthermore, recall that money market funds attempt to keep their Net Asset Value (NAV) close to $1 to ensure security of principle. Ultra-shorts are not constrained in this way and as such their NAV will fluctuate much more than their money market counterparts.

Additionally, compared to a CD which carries FDIC insurance and U.S Government notes which carry an implicit guarantee there are no such guarantees when it comes to investing in Ultra-Shorts. Therefore, it is important to understand the underlying portfolio of the fund you are investing in.

Despite these differences, Ultra-Short funds compensate with higher yields which make them potentially attractive to incorporate into our High Yield Bucket provided you are okay carrying some risk.

As an example of two funds that you can investigate, I ran a quick screen for Ultra-short funds with over Lipper Ratings (similar to Morningstar) of 4 or 5.

The first is the PIMCO Short Fund Class A (PSHAX). The fund has an objective of providing a higher yield that comparable traditional savings accounts and CDs while maintaining relatively low price volatility. PIMCO is a major name in fixed income investing and this particular fund has been around his 1987! PIMCO is a capable manager who understands these markets and has seen a lot happen over the past 30+ years. The fund’s yield (as of the end of March 2020) was 2.56% with an expense ratio of 75 bps (.75%). After the fee has been applied you are looking at a net yield of ~1.75% which is pretty attractive in this environment.

A look at the holdings though (again, as of end of March 2020) demonstrates the difference between these funds and the Money Market Funds we discussed earlier. You’re seeing many different types of instruments issued mostly by large multinational corporations with varying maturities and credit qualities. History has shown these funds to be pretty low risk in return for the yield you’re getting, but it’s important to understand what you’re buying.

The other is the Lord Abbett Ultra-Short Bond Fund (LUBAX). This fund was established only in 2016 and is relatively new especially compared to PSHAX. The fund comes with a yield of 1.53%, but with an expense ratio of only 45 bps (.45%) you’re still looking at a net yield of 1.08%. The fund appears to carry slightly higher credit quality which may make it overall a bit safer.

Conclusion

In this post we have taken a deep dive into cash management. Idle cash sitting in your bank account is doing you no good because you are earning no interest and even losing money if you factor in inflation. Furthermore, you don’t know what it is for! If you don’t have a plan for what cash is going where and why, then it’s going to be more difficult to manage and budget effectively. To that end, I introduced a framework that has you divide your cash into three distinct buckets all with a separate purpose and investment philosophy: an Operational Bucket, Emergency Bucket and High Yield Bucket.

Each bucket should only be used for the purpose for which it is intended. The investment strategies I have described are specific to each for that reason. As you can see you have a lot of different instruments at your disposal that you can mix and match as you please.

Hopefully this post has given you the insight and tools needed to build a better cash strategy. If you ever have questions, then please feel free to email me at admin@lightfinance.blog.

Until next time, thanks for reading!

-Aric Lux.